Hedging: The Forex Concept to Know

Much like in the stock exchange market, traders in the foreign exchange market also frequently turn to a trading tactic called hedging to minimize the risks involved in trades.

Hedging in the forex is much like acquiring an insurance policy in case a negative event occurs in the future. Note that hedging does not in any way prevent a negative occurrence from happening as they are done only to lessen the impact of such occurrences. Think of it as a house insurance to protect you from fires and other sudden accidents. In fact, insurance policies are a form of hedging themselves.

Hedging is done in the world of forex through tools that are called derivatives, financial instruments without inherent values making them the best hedges against unexpected fluxes in the market which they are not affected.

Futures contract is one of the most used types of derivatives in the forex. A futures contract is basically an agreement of a currency exchange to be done at a specified date with the exchange rate being the price on the last closing date. Futures are bought and sold in the market just like most financial commodities such as currencies and stocks.

Another example of derivatives is trading forex options. These derivatives allow traders to buy currencies from other traders for a fixed price, making forex options one of the best among other hedging tools.

An instance where trading option is used is as follows: Suppose you bought some amount of Euros with US dollars. After the exchange, let's say that you became a little worried that the value of the Euros that you just purchased might fall relative to the US dollar making your exchange unprofitable.

To protect yourself from such an event, you decide to purchase some options. Options do not cost much and the cost is but a fraction when compared to the potential losses you might incur in case the Euro really does fall relative to the US dollar. In the case that the feared scenario actually happen, the option can then be used to purchase US dollars with Euros at the level of price which you originally bought the Euros thereby nullifying the losses that you could have sustained.

If the scenario does not take place in the near future, you can still hold on to the option you bought. You can continue buying more Euros as you can always use the option that you bought in case the price of the Euro relative to the dollar falls.

Hedging is an important forex concept and it is imperative that every forex trader, especially the new ones, is knowledgeable of it as it is one of the most effective ways of avoiding the worst fear of any trader: currency flux. Hedging is the most effective tactic against this trader's scourge and this fact alone makes hedging a very important concept to master.